In a NutshellYou may have to pay capital gains tax on real estate if you sell property for more than its cost. Some capital gains from the sale of a primary residence can be excluded if you're eligible.
If you’re selling real property, you might owe capital gains tax.
Capital gains tax is often due when you sell assets for more than you originally paid. Capital gains tax applies to securities like stocks or bonds and tangible assets like real estate. You pay capital gains tax on the profit you get from selling an asset, which is the price you sell the asset for minus its adjusted basis.
The adjusted basis is a figure that shows how much the asset cost you. It’s the price you paid for the asset, plus or minus some adjustments that reflect how its value has changed over time.
The IRS allows many homeowners to avoid capital gains tax on the sale of their primary residence. But you may have to pay capital gains tax on a second home or rental property. And you might owe capital gains tax on your primary home if you’ve lived in it for less than two years, or if its value has gone up dramatically.
- Capital gains tax on real estate
- When do you have to pay capital gains tax?
- Capital gains tax differences for primary residences vs. rental properties
- How to avoid capital gains tax on real estate
Capital gains tax on real estate
How much capital gains tax you owe from selling property depends on several factors.
- If you’ve owned the property for more than a year, your gains from selling it are generally considered long-term gains, and you may pay a lower rate.
- If you’ve owned the property for less time, your gains are short-term gains, and you pay income tax on them according to your tax bracket, just as you would for other income.
Whether you have long-term or short-term gains, your income level and tax filing status affect the rate you pay.
Exclusion for primary residences
Under some conditions, the IRS lets you avoid capital gains tax on the first $250,000 in gains on the sale of a primary residence (or $500,000 for a married couple filing jointly).
To get this exclusion, you typically need to have owned and used your home as your primary residence for at least two years total out of the last five years before selling it. And you can take this exclusion once every two years at the most.
When do you have to pay capital gains tax?
You may have to pay capital gains tax after selling property if you realize a capital gain. That happens if the price you sell the property for is greater than its adjusted basis.
You might owe capital gains tax if you’re selling your primary home and don’t qualify for the exclusion. That could happen if you’ve owned or lived in the home for less than two of the past five years or excluded gains on a different home sale within the past two years.
You might also owe capital gains tax on the sale of your main home if you previously rented it out. And you could owe capital gains tax on your primary home if your gains are greater than $250,000 (or $500,000 if you’re filing jointly with a spouse).
Capital gains tax differences for primary residences vs. rental properties
While it’s often possible to exclude capital gains on a primary residence, that doesn’t apply to rental property. So selling a rental property may generate a much larger tax bill.
Another difference is that you may have depreciated a rental property or taken an income tax deduction each year to account for the property’s decline in value over time. The IRS requires you to lower the property’s basis by the total amount of depreciation permitted, whether or not you took this deduction.
Reducing the basis increases your gain on the sale. The part of the gain added due to depreciation may be taxed at a 25% rate. Also, you may have to pay Net Investment Income Tax on the sale of a rental property or a second home at a rate of 3.8%. This tax on capital gains and other investment income kicks in if your income exceeds a set limit.
How to avoid capital gains tax on real estate
If it looks like you’re going to be hit with a capital gains tax bill on a real estate sale, you may be able to do some things to reduce the amount you owe or even avoid paying capital gains tax altogether.
If you’re selling a primary home …
If you sell a primary home, you might face capital gains tax because you excluded gains from a home sale in the last two years or haven’t lived in the home long enough. In those cases, it could be worth waiting to sell and using the home as your primary residence to qualify for the exclusion.
Because rates on long-term capital gains are generally lower than short-term gains, simply holding onto a property for at least a year can lower your tax bill compared to selling it before a year ends.
If you’re selling a rental property …
If you’re selling a rental property, you might want to move into it and use it as your primary home until you qualify for the primary residence exclusion. However, you may not enjoy the full benefit of the exclusion because you won’t be allowed to exclude gains that correspond to the period you rented out the property or gains equal to its depreciation.
Alternatively, you might be able to postpone paying capital gains tax on a rental property if you use the proceeds to buy another rental property in the U.S. in a transaction that the IRS calls a like-kind exchange.
For this to work, you must decide which property you’re buying within 45 days of selling your rental, and you must take ownership of the new property by a deadline that will be 180 days out or by the due date of the tax return, whichever is earlier. Remember that you can only make a like-kind exchange for another rental property, so you can’t go this route to buy a home for your own use.
If you’re selling a home or a rental property …
Whether selling a home or a rental property, you could trim your tax liability by adequately adjusting the basis. You can add settlement fees and closing costs from the property’s purchase to the basis. You can also add the cost of additions and improvements. To qualify as an improvement, the work must add value to the property, boost its durability, or allow it to be used for a different purpose. You could add repairs if they were included in a more extensive remodel. Finally, you might consider selling an investment at a loss to cancel out some of your gains from the real estate sale.
If you think you’re going to owe capital gains tax on a real estate sale, it makes sense to connect with a financial adviser or a real estate attorney. They can help you understand the tax issues around your sale and answer your questions. Also, you should be aware that you might need to make estimated tax payments if you owe capital gains tax.
How is capital gains tax calculated on real estate?
Capital gains tax is calculated as the difference between the sale price of the property and the property’s adjusted basis. The adjusted basis is what you originally paid for the property, plus adjustments that raise or lower that number. This gain is multiplied by the tax rate, which depends on factors like your income tax bracket and how long you owned the property.
What is the capital gains tax rate for 2023 on real estate?
Your tax rate depends on several factors, such as income and filing status. Short-term capital gains are taxed along with the rest of your income according to your tax bracket. Most people won’t pay more than 15% on long-term capital gains, but a 20% rate applies to high earners.
Who is exempt from capital gains?
You might not have to pay capital gains tax on the first $250,000 in gains on the sale of your primary home (or $500,000 if you’re married and filing jointly) as long as you meet specific requirements. You must have owned the property and lived in it as your main home for two of the past five years. And you can’t take advantage of this exclusion more frequently than once every two years.